Safe haven flows that favoured the dollar have been reversing. Carry trades always defy measurement, but such positions, with the dollar as a funding currency, are thought to be increasing, putting upward pressure on higher-yielding currencies. And with asset prices rising, the hedging US dollar holdings by European and Australian institutional investors also weighs on the dollar.
In contrast, while the spread between Libor and expected overnight rates has normalised, the premium on dollars in swap markets is still providing some support to the dollar.
Write-downs of dollar assets by non-US banks continue, albeit at a reduced pace, and are said to have some way to go. These will likely leave investors with overhedged dollar books. Squaring these positions, which will require dollar purchases, will further boost the currency.
It is worth noting that, at current US yields, carry trades and institutional investors’ hedges respond similarly to big changes in asset prices and volatility. In particular, when equities fall, risk appetite shrinks and volatility increases, dollars are bought by both types of investors, as in late 2008; with “risk on”, equity prices rising and declining volatility, dollars are sold by both, albeit perhaps at different frequencies.
This is a summary of research from the BIS Quarterly Review